[RFC]: Community Fund - DPI INDEX Proposal

[funkmasterflex]

Nexus Mutual - Community Fund - DPI INDEX Proposal

Co-authors: funkmasterflex, Marc (Miza 6), Matthew Graham, @HelloShreyas

We appreciate the assistance and insights from @Dopeee and the groundwork done by the Investment Hub including @Rei, @aleks, @nsantini, @Gauthier, @oSaaT, and @JC1

Basic Summary

We are requesting feedback from the Nexus community regarding Index Coop Products and propose to invest a percentage of the Nexus Mutual capital pool into the DeFi Pulse Index (DPI). This proposal is following the Investment Hub Update forum post written by Rei mentioning further research on passive/index strategies like DPI.

The DPI is a capitalization-weighted index that tracks the performance of the top DeFi tokens. It is currently composed of 16 popular DeFi tokens available on Ethereum. The methodologist behind DPI is Pulse, Inc, creators of DeFi Pulse and the criteria for token selection can be found here.

DPI is the most popular DeFi index product with, at the time of writing, ~$200M of market cap. A 0.95% annual fee for the management of this product. It covers the costs with portfolio rebalancing and the implementation of the methodology.

DPI is built on top of Set Protocol and managed by Index Coop. Index Coop is a decentralized and autonomous asset manager governed, maintained, and upgraded by INDEX token holders.

Motivation

The main purpose of this initial investment into DPI is to fulfill the goals outlined by the Investment Hub; maximize the return obtained on the assets sitting in the capital pool, while minimising associated risk.

More specifically, the Investment Hub’s objective is to create a diversified portfolio of assets while ensuring sufficient liquidity to meet cover obligations. By gaining exposure to a diverse basket of top DeFi projects, Nexus Mutual can build a larger capital pool while still meeting all of these goals.

DPI is an efficient way to get exposure to the DeFi sector. The index gives exposure to all the component tokens while only having to hold one single token. The top 7 tokens of DPI represent ~90% of the Index portfolio (Uniswap, Aave, Maker, Compound, Sushi, Yearn and Synthetix). It is more efficient to pay the 0.95% annual management fee than do the implementation alone, spending with gas and development costs to do the rebalances.

Nexus Mutual provides cover to 15 of 16 projects within DPI and 227.6k ETH of total coverage. In addition, the Mutual has 10.5k ETH of cover on Set Protocol V1 and V2.

Risk Assessment

The following assessment is based on the “Qualitative vs. Quantitative Risk Assessment” outlined in the Investment Philosophy forum proposal.

Illiquidity Risk: DPI can be liquidated in 72 hours or less (Low Risk)

Minting and redeeming DPI represent the primary market of the indices, but many users can buy and sell indices on the secondary markets. The price on the secondary markets are kept at Net Asset Value (the market value of all the underlying components) through a network of market makers that redeem the tokens when price is below NAV and vice versa.

When considering liquidity, the average daily trading volume is $7.75M, based over a trailing 90 day trading period. However, as DPI holders have the option to mint/redeem the underlying tokens within DPI, it draws on the liquidity of the underlying assets and also allows for any deviation from NAV to be arbitraged away by traders.

Basis Risk: Medium Risk

As DPI is a basket of tokens, it has less volatility than the component assets by themselves. This is reflected by DPI having a standard deviation of 6.5% considering the last 6 months.

As shown in the table below, DPI has performed in line with BTC and ETH since inception, at the cost of a 1-2% increase in volatility depending on the benchmark. The correlation of DPI with ETH is 0.80 and with BTC is 0.58. It is a way to diversify a bit from only holding ETH.

Protocol Risk: Lower Risk

84% DeFi Safety Score

Set Protocol V2, and therefore DPI, was audited by OpenZeppelin in September of 2020, launched early October 2020, and has over 150,000 user transactions. Additionally, audits from Chainsecurity and Trail of Bits were completed on Set Protocol V1.

Liquidation Risk: No liquidation risk (Lower Risk)

Leverage Risk: No leverage (Lower Risk)

Counterparty Risk:

DPI holders have no governance influence on Index Coop or the protocol within the index. The DPI utilizes TokenSets V2 smart contract that has privilege roles in many of the contracts. The key findings from the audit are highlighted below:

• The Controller contract has an owner that chooses the contracts that comprise the system. This includes all of the modules, resources and the factories that can be used to make Sets.The owner also has the ability to remove Sets as desired, and specify protocol fees and other fee types that conforming modules will pay. Moreover, user deposits are achieved by granting token allowances to the Controller, so a malicious owner could deploy a module that simply takes these tokens.
• The IntegrationRegistry tracks third party integrations that can be used in the system. It also has an owner that can add, remove and edit the integrations as desired.
• The PriceOracle has a list of oracles and adapters that can be used to retrieve third party prices. It also has an owner role that can choose the supported oracles, adapters and price pairs.
• A malicious or poor choice of token contracts can undermine the value of the Set, so it is up to the set creators to choose sensible component distributions, and users will need to trust the creator or validate the choices.

There is a multisig responsible for initiating rebalances, performing meta-governance, adding / removing new protocol functionality. It does not have the ability to arbitrarily move underlying assets, mint tokens, etc. The signers are currently members of the Set team with the intention to add Index Coop community signers over time. While the multisig can’t arbitrarily move assets, it theoretically could rebalance assets into a fake token. The mitigating factors for these risks are the Set Labs, DeFi Pulse and individuals personal reputation.

Implementation

There are several methods available for purchasing DPI.

This initial proposal is to gauge support, if it is decided that it would be in the best interest of the community, we can determine the best way to implement the sale. Some examples, direct buy through Token Seats, Bonding Curve, Marketmaking Partners, Balancer pool.

For large trades TokenSets offers investors the ability to “Buy” DPI via exchange issuance. Investors are able to send ETH, receive DPI and in the background the individual underlying assets are purchased. The “Buy” functionality draws on the liquidity of the underlying assets within DPI.

A bonding curve was recently utilized by FEI/Tribe for a $25 Million purchase using PCVSwapper code (recently increased to $50). This is audited code written to buy DPI on secondary markets. We can specify a value and frequency to minimize price impact. This would require a Chainlink Oracle.

Other alternatives are a custom Balancer pool or we can work with our Market Making partners to facilitate trading that will minimize price impact of a large sale.

Again, this proposal is to open discussion on if Nexus should diversify its treasury, we can discuss “The How” as a next step. We are open to discuss what would be the best implementation strategy.

Other Treasury Considerations

The purpose of this post is to spark a productive conversation between our two communities. Nexus Mutants and Index Coop Owls are well aligned on many aspects within crypto and DeFi; risk management being most critical. As the Nexus capital pool continues to grow and minimal capital requirements fluctuate, we are happy to discuss other correlated and non-correlated investments such as MVI and DATA.

Upcoming products like Pulse Aggregate Yield for tokenized stablecoin yield and more productive indices like Yield Hunter Index may also fit well. The Index Coop Community and our internal treasury team are excited to endeavor into more collaborative research regarding treasury management strategies.

Voting Rules

We would like to gather feedback from the community about this post and invite communities to discuss how a DPI purchase could benefit Nexus Mutual.

[Hugh]

Thanks to the Index Coop team for a well laid out post. Appreciate the effort you’ve all put into this.

Questions I think we should be considering:

1. Is a DeFi basket a good investment for the mutual?

• What’s the alternative, is it expected to outperform holding staked ETH?

• Are the correlation issues potentially too much?

My general feeling is if we believe DPI can and should outperform staked ETH then there is room for a small allocation, 5 - 10%, for more “equity” style investments. Usually insurance companies have small equity allocations but are mostly bonds/cash equivalents. I’m not too worried about the correlation issues, which are mostly second order anyway, at this allocation level.

I’m honestly not sure on the first point though, ie can DPI expect to outperform stETH. It may just introduce more volatility and downside in massive crypto drawdowns, which is where Nexus wants to be the most resilient (protocols most likely to break). Would appreciate comments from the investment committee and others on this aspect.

2. If a DeFi basket is a good investment is DPI the best one for the mutual?

I haven’t done a lot of research here, but I believe DPI is the biggest/most liquid basket out there. It would be great if someone could put together some key stats here, or maybe there is an existing Dune dashboard?

3. wen wNXM in DPI?

[funkmasterflex]

Hi @Hugh, thanks for the feedback!! We agree that stETH is 1) a productive and capital efficient investment in the “cash” of the ecosystem and 2) a long term bet on a high growth ecosystem. There are risks involved when staking ETH and these were concisely laid out by Rei and the Investment Committee.

Because of the concentrated exposure of stETH with Lido, the cap has been appropriately set to 18.5% for now. A complementary investment would be an asset with a slightly different correlation that provides the necessary diversification to the portfolio in order to mitigate the risks of the unknowns and offset concentration risk over time. @Hugh makes an apt comparison to the traditional world; “a small allocation, 5 - 10%, for more “equity” style investments”.

This can similarly be considered a strategic investment. To be clear, DPI is further down the risk curve than ETH, but DeFi tokens could be strategic investments with an asymmetric risk return profile. DeFi tokens can be treated as such a strategic asset, but because of the coverage obligations, high allocations to single assets within DeFi would be riskier.

This risk is further exacerbated if the single treasury owned assets experience smart contract failures that must be covered by Nexus. To ensure resiliency of the Mutual a diversified basket like DPI is a prudent answer.

Hugh raised a fair question “is DPI expected to outperform holding staked ETH?” What is clear is that DPI has a correlation to ETH, but DPI has the benefit of exposure to protocols that have a potential for breakout performance growth. These protocols simultaneously offer robust and diverse value streams that are unique compared to just purely ETH transaction fees. As L2s and other L1s grow, this gives further diversification and potential for DPI outperformance. Consider Sushi; launching on multiple chains, consistently rolling out massive new products, and continually returning value to token holders. This performance can and has proven to outperform ETH for certain periods in specific markets while still staying highly correlated on downturns. An example of the former can be seen in the outperformance of DeFi tokens vs ETH in periods between May and December of 2020. As protocol teams continue to deliver and the space matures for investors, we believe there is a strong possibility these assets over a long enough time span will appreciate at a higher rate versus more consistent and cash-like instruments like ETH or stETH.

Below is a quick comparison of Index Coop products versus competitors in the space. The chart, updated 9/17/21, shows Total Value Locked by all major players in the ecosystem.

When comparing index providers in the space, Index Coop far surpasses others in categories like number of products launched, audits/security, and awareness. Further statistics including unique holders and trading volume on DPI can be found here: https://dune.xyz/jdcook/DPI. DPI is by far the largest and most liquid index by volume. Because Set Protocol fully collateralizes the underlying assets within the token, it also has added liquidity benefits available on decentralized exchanges. .

We’re excited to be collaborating with Nexus in these important treasury decisions. We understand the unique aspects of the capital pool and can try to provide a solution specifically tailored to your needs.

[Dcc]

My take is that it’s a well thought out proposal but I’m uncertain that the mutual can be comfortable that it will outperform StEth and there is a non-trivial risk of underperformance to currently warrant an allocation.

When insurance companies have small equity allocations they are ultimately accessing a distinct risk premia with a long-term track record of outperforming the fixed income / cash component and I’m just not comfortable that defi tokens offer this in relation to StEth. The upcoming merge would also make me wary of introducing basis risk at the current time.

Whilst the top 7 tokens in DPI are some of the most battle hardened protocols out there if there was to be a major hack it would seem extremely unlikely that this wouldn’t lead to negative price performance in DPI at the same time that the size of the mutual would be reduced by payouts. Similarly as mentioned by Hugh, in major eth drawdowns the levered nature of most Defi tvl means it’s challenging to see a scenario where DPI outperforms.

I personally think looking at the Pulse Aggregate Yield product which has effectively been touched upon in the Stable Yield Index (SYI) post from May 2021 is a far better fit - especially if the Mutual could locate some insurance from one of the other providers in the space to mitigate some of the protocol risk.

[oSaaT]

Dear DPI team,

Thank you for reaching out with this proposal. Please treat this reply as a collaborative effort from the Investment Hub.

First of all, we are impressed by the proposal’s quality, and really enjoyed seeing the structure of our investment philosophy being followed so closely.

Also, we are thankful that you’re addressing the critical topic of technical implementation.

As mentioned in various places, Nexus is focusing its Dev resources on the mutual side of the protocol, so ease of implementation for an investment strategy is definitely a plus point.

This being said, our further comments may reflect some of the doubts already expressed by Hugh and the wider membership base.

1. We believe DPI is a tremendous product for investors seeking broad or passive exposure to DeFi (and especially to DeFi future promises).

As a mutual, our investment philosophy for our Capital Pool (not our community treasury) has to be more conservative than for the average DeFi investor.

We are open to a certain share of higher-risk equity-like investments, provided those show an attractive reward profile vs. ETH (or staked ETH) and are managed more actively in order to limit downside volatility. In other words - providing hedging of some sorts.

At the moment, we fail to see convincing arguments for the underlying tokens of the index outperforming ETH over the next year and, in the case of a sell-off or a sustained bear market, we assess the likelihood of these tokens underperforming ETH as quite high without a hedging backstop.

2. We believe the Set Protocol and TokenSets is a very sound protocol within the DeFi space.

Similarly, looking at investments within DeFi for a mutual, we have to be strict in the layers of protocols for each investment. Adding an extra protocol layer has to come with clear benefits; this would be the case for example for the management of a strategy with a higher level of maintenance, or to facilitate its technical implementation.

3. We also believe your value proposition is certainly worth the modest fee for a wide variety of investors.

In the case of the capital pool of Nexus, even an allocation in the single-digit % would be a significant amount. A modest fee %-wise would still represent a large absolute amount for us, especially when discussing a passive strategy.

For some context, at the Investment Hub, we tend to take a long and deep look at fees of various investments available.

We think there is ample room within DeFi to be more creative with the fee structure around protocols and investments, leaving the legacy of TradFi where it is not applicable or necessary any longer.

To sum up, the discussions that we’ve had amongst ourselves and with the community did not result in a strong signal to implement a DPI allocation at this time. There was clearly a concern around long-term underperformance vs. (staked) ETH and preference for a more active strategy which limits downside vs. ETH and/or identifies early opportunities.

Once again, we really appreciate the time you took to put this together and would welcome a follow-up conversation to discuss potential collaboration opportunities in future.